How to trade Forex with Bollinger Bands
Similar to their stock trading counterparts, Forex traders generally employ one of two approaches when analysing the market: the fundamental approach and the technical approach.
The focus here will be on the technical approach to analysing the currency market, and more specifically, one particular tool traders can use in technical analysis: Bollinger Bands. There are many advantages to using the Bollinger Bands, but like any other trading tool it is not meant to be used in isolation but in conjunction with other methods. Bollinger Bands should not be the primary basis for any buy or sell decision.
What Are Bollinger Bands?
Bollinger Bands are technical charts that are based on a statistical measurement known as standard deviation. Using this principle, Bollinger Bands measure the rate of volatility in the market. As the name indicates, Bollinger Bands are bands that can be seen on a computer screen which widen and contract according to the level of fluctuation that exists in the market.
In times of increased fluctuation the bands widen and when the fluctuation decreases they contract or taper off to reflect the average price range.
Bollinger Bands consist of three parts: the upper band, the lower band and the middle band. The middle band represents the moving average against which the upper and lower bands are measured. All three bands interact according to volatility. Here’s a great infographic from Hantec Markets explaining Bollinger Bands in more detail.
How to Use Bollinger Bands
The Bollinger Bands (as indicated earlier) are not meant to be used as a buy or sell indicator. However they can be used to observe price trends and by extension give the trader an idea as to where the prices may be headed. In this regard, there are two common strategies used when observing these bands to guess the direction of prices: the Bollinger Bounce and the Bollinger Squeeze.
The Bollinger Bounce is based on the idea that prices eventually go back to their middle band (average price range).The bands (like physical ones) widen and contract according to the level of external force-in this case prices. By observing this movement, traders can make an educated guess on where and when prices will settle down to normal levels. This strategy is ideal for situations where there is no clear trend.
When the bands squeeze together, that is an indication that a breakout in imminent. If the candles break out at the top, this means that prices will continue on an upward trend. If the break occurs below the band that means that the trend will continue downward. This strategy is designed to help traders spot an early trend.
Interpreting Bollinger Bands
When observing Bollinger Bands, traders should keep four general rules in mind:
1. When a price moves to the upper or lower band, look to other indicators to confirm what the band seems to be telling you. These indicators should confirm whether there is price strength or weakness. If the indicators do not confirm the movement of the bands then this could be interpreted as a possible price reversal.
2. If a top or bottom can be observed outside the band followed by another top or bottom within the bands then this could indicate a trend reversal.
3. If a move originates in one band, the tendency is for this move to be repeated in the other band.
4. Sharp moves tend to follow the tightening of bands along the moving average, indicating relative price stability. The longer the period of stability the more likely a breakout will occur.
How Bollinger Bands help Trading Decisions
Bollinger Bands help traders in three main areas: breakouts; reversals and range trading. Breakouts occur right after a band contracts as this is an indicator of low volatility. Reversals occur when the daily range is outside the bands. In range trending you buy if the price hits the bottom band and sell if the price is at the top. For traders who employ leveraging techniques the Bollinger Band indicators can be extremely useful as when prices are thought to be going in a certain direction the trader can make decisions with far less risk.